Big Winners for Small Investors

A Midwest billionaire once boasted he could earn you 50% year after year on a portfolio of common stocks. Of course, there's a condition.

Or maybe that's an urban legend. After all, it's been debated for years. So, I ask you: Did this guy really make that claim? And if so, what was that one condition?

Enter a flock of Jayhawks
While we debated who said what and when, a bunch of meddling kids did something about it. They kicked their way across Kansas and met with the legendary investor.

And they asked him: Did the so-called world's greatest investor really make that "50% per year" guarantee? And more important, would he stand by it today? As it turns out, he didn't just confirm that it was true -- he went a giant step further.

You'll be surprised how he would do it
To earn you 50% per year -- essentially doubling your money every 20.5 months -- the world's greatest investor wouldn't buy the giants like Washington Post (NYSE: WPO) that made him a legend, or even his own $220 billion company.

He'd buy obscure outfits with names you've never even heard of. How do I know? He told us. Remember that one condition?

Well, this fellow would guarantee you 50% per year ... only if he had less than $1 million to invest. That's because he would be loading up on undiscovered, thinly traded small caps -- the one spot in the market where individual investors like us have an advantage over the pros.

Why Warren Buffett wishes he were you
You knew it was Buffett, didn't you? Well, can you guess why he wishes he were you? Because he has too much money. I know, that sounds nuts. After all, the big money on Wall Street has all the advantages.

Right?

Wrong.

For one thing, most pros have way more than $1 million to invest, so they can't mess with great small companies -- at least not without taking the risk of running up the price or buying a controlling stake in the firm.

That's why you see so much trading volume in the mega caps. Take a look at these usual suspects among the most widely owned and heavily traded NYSE stocks.

And over on the Nasdaq? How about Research In Motion (Nasdaq: RIMM), weighing in at $60 billion and trading nearly 25 million shares a day? On Wall Street, they call this liquidity -- a polite way of saying "the usual suspects buying and selling the same old stocks to each other."

So, if you've got half a billion to put to work this afternoon, you'd better buy something big and forget about the next big thing. But don't expect to be dazzled; those usual suspects don't have many doubles left in the tank -- much less one every 20 months or so.

Wait a minute! Aren't small companies risky?
Not necessarily. Ibbotson Associates tracks stock returns by "style" and market cap. You could have invested $1,000 in Ibbotson's large-cap universe back in 1927, and you'd have about $2 million today. Not bad.

If you'd bought small-cap value stocks instead, you'd have $33 million. Of course, the word "value" here is critical. In fact, combining small-cap potential with old-school value is the missing link between big profit potential and the method to Buffett's madness.

Motley Fool co-founder Tom Gardner hammered this lesson into my head back when I worked with him on his Motley Fool Hidden Gems newsletter. So, as you'll see for yourself in a moment, I know firsthand how fantastic the returns can be when you focus on unloved, obscure, and (most important) underpriced small companies.

Yes, there are bargains out there
The recent volatility and slow rotation into mega caps is a great opportunity for small-cap investors like us. Seriously, if you want to see how Tom has beaten the market three years running with small-cap value stocks, there's never been a better time.

Especially now that you can give Hidden Gems a try for free. I have a hunch that it can help make you some money (already, two dozen Hidden Gems recommendations have doubled or more). I guarantee that it'll make you a better investor. If you have less than $1 million to invest, that is.

Best of all, there's no risk. If you're not absolutely convinced at any point during the first 30 days, I'll personally make sure Tom doesn't charge you a dime. Even Buffett would be proud. To learn more about this free trial offer, click here.

This article was originally published on Feb. 10, 2006. It has been updated.

Paul Elliott promises to keep you posted on Tom Gardner's results. As of this morning, the stocks highlighted in Hidden Gems are up an average of 49.9% versus 19.6% if you'd bought the S&P 500 instead. You can view the entire scorecard with your free trial. Paul owns shares of Bank of America, which is an Income Investor recommendation. The Fool has a disclosure policy.